Ch 13 — Positive Externalities and Public Goods
Markets tend to under-produce goods that generate positive externalities because private decision-makers capture only part of the total social benefit. This chapter examines how technology, education, and vaccinations create spillover benefits, how governments encourage innovation through intellectual property rights and R&D funding, why public goods suffer from the free rider problem, and how common resources face the “tragedy of the commons.”
Table of Contents
1. Investments in Innovation
Why Competition Alone Is Insufficient
Market competition incentivizes firms to innovate — higher profits reward those who produce more cheaply or create products consumers want. However, competition can discourage innovation when:
- Other firms can quickly copy a new idea
- R&D is expensive and risky (e.g., a new drug costs ~$800 million and takes over a decade)
- The innovator bears all costs but captures only a fraction of total benefits
Historical Inventors Who Received Little Reward
| Inventor | Innovation | Outcome |
|---|---|---|
| Eli Whitney (1765–1825) | Cotton gin | Southern planters copied design; courts wouldn’t uphold patent |
| Thomas Edison (1847–1931) | Automatic vote counter (first invention) | Could not find a government buyer |
| Gordon Gould | Laser (1957) | Delayed patent; spent $100,000 on legal battles; patent granted 1977 |
| Alan Turing | Universal computing machine (1936) | Father of computer science & AI; received no financial reward |
Studies find the original inventor receives only one-third to one-half of total economic benefits from innovations.
Private Benefits vs. Social Benefits
Private benefits — the profits a firm receives from its own innovation.
Social benefits — private benefits plus all positive externalities (spillovers to other firms and society).
\(\text{Social Benefit} = \text{Private Benefit} + \text{External Benefit}\)
Because social benefits exceed private benefits, firms underinvest in R&D relative to the socially optimal level.
The Big Drug Company Example
Big Drug Company faces an 8% interest rate on borrowing. Its demand for financial capital differs depending on whether it captures only private benefits or the full social benefits:
| Rate of Return | DPrivate ($ millions) | DSocial ($ millions) |
|---|---|---|
| 2% | $72 | $84 |
| 4% | $52 | $72 |
| 6% | $38 | $62 |
| 8% | $30 | $52 |
| 10% | $26 | $44 |
Key Insight: At 8% interest, the firm invests only $30 million (private), but the socially optimal investment is $52 million. The gap of $22 million represents underinvestment due to positive externalities.
Human Capital Investment
Education is an investment with both private and social returns:
| Education Level | Median Weekly Earnings (2021) |
|---|---|
| Less than high school | $651 |
| High school degree, no college | $831 |
| Bachelor’s degree or higher | $1,467 |
- Private rate of return to college education: approximately 10–15%
- Social rate of return is also positive (George Psacharopoulos research)
- Positive externalities of education include: better health outcomes, lower crime, cleaner environment, more stable democracy (Walter McMahon)
Vaccinations as Positive Externalities
Vaccinations protect not only the individual but create spillover benefits by reducing disease transmission.
Flu Shot Market
- DMarket reflects only Marginal Private Benefit (MPB)
- DSocial = MPB + spillover benefits = Marginal Social Benefit (MSB)
- Market produces QMarket — too few flu shots
- Socially optimal quantity is QSocial > QMarket
Policy Solution: Government provides a subsidy (voucher) equal to the per-unit spillover benefit → shifts consumption to QSocial. Suppliers receive PSocial; consumers pay only PSubsidy.
Diagram — Positive Externality: Subsidy Corrects Underproduction:
\[\text{Optimal subsidy} = MSB - MPB = \text{per-unit spillover benefit}\]ICT and Environmental Externalities
Economist Carlota Perez studies how technological revolutions create initial disruption followed by long-term benefit:
- Unlike the Industrial Revolution, the Information & Communications Technology (ICT) revolution has potential for positive environmental externalities
- Vehicle sharing, product rental-reuse networks, and online shopping reduce fossil fuel consumption
- Most studies find online shopping is better for the environment than in-person shopping (fewer individual car trips vs. efficient truck deliveries)
2. How Governments Can Encourage Innovation
Three main policy tools:
Tool 1: Intellectual Property Rights
Intellectual property — the body of law including patents, trademarks, copyrights, and trade secret law that protects the right of inventors to produce and sell their inventions.
- Patent: exclusive legal right to make, use, or sell an invention for 20 years
- Copyright: exclusive legal right over works of literature, music, film/video, and pictures
Mickey Mouse & the Sonny Bono Copyright Term Extension Act (1998)
- Mickey Mouse’s copyright was set to expire in 2003
- Congress extended copyright for companies from 75 → 95 years after publication
- For individuals: 50 → 70 years after death
- Affected about 400,000 books, movies, and songs
Limitations of patents:
- Inventors receive only 1/3 to 1/2 of total economic value
- In fast-moving industries (biotech, semiconductors), patents may be almost irrelevant
- Not every idea can be patented (e.g., new factory organization, employee training methods)
- Patents may cover too much (Xerox had 1,700+ photocopier patents in the 1970s)
- The 20-year period is somewhat arbitrary
Tool 2: Government Spending on R&D
| Source of R&D Funding | Amount ($ billions) | % of Total |
|---|---|---|
| Federal government | $129.6 | 21.4% |
| Industry | $426.0 | 70.3% |
| Universities and colleges | $20.7 | 3.4% |
| Nonprofits | $25.0 | 4.1% |
| Nonfederal government | $4.8 | 0.8% |
| Total | $606.1 |
Source: U.S. R&D Expenditures, 2018 (NSF)
Historical Shift: In the 1960s, the federal government paid for about two-thirds of the nation’s R&D. Today, industry funds about 70%. The challenge: government funding inevitably involves political decisions about which projects deserve support.
Tool 3: Tax Breaks for R&D
The Research & Experimentation (R&E) Tax Credit stimulates private-sector investment:
“Each dollar of foregone tax revenue through the R&E Tax Credit causes firms to invest at least a dollar in R&D, with some studies finding a benefit-to-cost ratio of 2 or 2.96.” — U.S. Treasury Department
Cooperative Research
- NIH-supported research added $69 billion to GDP and supported 7 million jobs in 2011
- The U.S. spent $117 billion on medical research in 2011
- Federal grants fund the National Academy of Sciences, National Academy of Engineering, and the Agriculture and Food Research Initiative (AFRI)
3. Public Goods
Definition
A public good has two defining characteristics:
- Nonexcludable — it is costly or impossible to exclude someone from using the good
- Nonrival — when one person uses the good, it does not prevent others from using it
Examples: national defense, fire & police protection, tornado sirens, street lights, lighthouses
Four-Way Classification of Goods
| Excludable | Nonexcludable | |
|---|---|---|
| Rival | Private good (pizza, laptop) | Common resource (ocean fish, conch) |
| Nonrival | Club/quasi-public good (satellite radio, cable TV) | Public good (national defense, public radio) |
The Free Rider Problem
Free rider — a person who wants others to pay for the public good and then plans to use the good without paying.
Rachel and Samuel — Prisoner’s Dilemma for Public Goods
- Rachel reasons: “If Samuel doesn’t contribute, I’d be a fool to contribute. If Samuel does contribute, I can come out ahead by not contributing.”
- Either way, Rachel chooses not to contribute (hoping to free ride)
- Samuel reasons the same way
- Result: The public good never gets built — even though cooperation would be best for both
This is the classic prisoner’s dilemma applied to public goods provision.
Free Rider Payoff Matrix (Rachel & Samuel):
| Samuel: Contribute $50 | Samuel: Free Ride | |
|---|---|---|
| Rachel: Contribute $50 | Both get $80 benefit (net: +$30 each) | Rachel pays $50, gets $40 benefit (net: −$10); Samuel gets $40 free |
| Rachel: Free Ride | Rachel gets $40 free; Samuel pays $50, gets $40 (net: −$10) | Neither contributes → no public good → $0 each |
Dominant strategy: Free ride (regardless of what the other does). Result: public good is never provided.
Solutions to the Free Rider Problem
| Approach | Mechanism | Example |
|---|---|---|
| Government provision | Taxes fund public goods; law requires everyone to contribute | National defense, public sanitation |
| Advertising model | Indirect charging through ad revenue | Radio broadcasting |
| Subscription model | Make the good excludable via technology | Satellite radio (Sirius XM) |
| Mixed model | Free access + fees for specific uses | Public parks with paid parking/reserved spots |
| Social pressure | Community norms encourage participation | Neighborhood associations, charity fundraising |
4. Common Resources & Tragedy of the Commons
Common resources — goods that are nonexcludable but rival in consumption. Because anyone can access them but each unit consumed reduces availability for others, they tend to be overharvested.
The Queen Conch (Caribbean)
- Large marine mollusk in shallow seagrass waters
- Nonexcludable: almost anyone with a small boat and snorkel can harvest
- Rival: each conch caught by one diver is unavailable to another
- Result: overharvesting → U.S. effectively banned harvesting since 1986
Policy tools to address overharvesting:
- Fishing licenses
- Harvest limits
- Shorter fishing seasons
- Catch shares — regulators set total allowable catch and allocate portions to fishermen
Elinor Ostrom’s “Non-Tragedy of the Commons”
Elinor Ostrom, the first woman to receive the Nobel Prize in Economics, challenged the idea that only regulation and property rights prevent resource depletion. Through fieldwork in Indonesia, Kenya, Maine (U.S.), and Nepal, she showed that:
- Communities can communicate and cooperate to manage shared resources
- Resources are better managed without external influence when beneficiaries are in close proximity to the resource
- Coined the concept of the “non-tragedy of the commons”
5. Positive Externalities in Public Health
One of the most remarkable improvements in living standards: life expectancy
| Period | Life Expectancy |
|---|---|
| Thousands of years ago | 20–30 years |
| 1900 (U.S.) | 47 years |
| 2015 (U.S.) | 79 years |
| 2020 (U.S., due to COVID-19) | 77 years |
Three Primary Factors
- Clean water & sanitation systems — prevented transmission of many diseases (public goods)
- Changes in public behavior — boiling bottles, handwashing, food protection from flies, reduced smoking, precautions against STDs
- Medical advances — immunizations (diphtheria, cholera, pertussis, TB, tetanus, yellow fever: 1890–1930), penicillin (1941), blood pressure drugs
Technology & Inequality: Economist Tyler Cowen (George Mason University) warns that the benefits of technology spillovers are not shared equally. In his 2013 book Average Is Over, he argues that inequality in access to technology deepens inequality in skills, wages, and global standards of living.
6. Key Takeaways
- New technology creates positive externalities — spillovers benefit firms and society beyond the innovator
- Inventors capture only 1/3 to 1/2 of total economic benefits → markets underinvest in R&D
- The social benefit of an innovation = private benefit + external benefit
- Government encourages innovation through: intellectual property rights, direct R&D funding, tax breaks, and cooperative research
- A public good is nonexcludable and nonrival — markets struggle to provide it
- The free rider problem (prisoner’s dilemma logic) explains why voluntary provision of public goods fails
- Common resources (nonexcludable + rival) face the tragedy of the commons — overharvesting/overuse
- Elinor Ostrom showed communities can manage commons through communication and cooperation
- Positive externalities in public health (sanitation, vaccines, medicine) dramatically increased life expectancy
- Government subsidies can correct underproduction by shifting consumption to the socially optimal quantity
7. Practice Questions
Q1. Do market demand curves reflect positive externalities? Why or why not?
Answer
No. Market demand curves reflect only marginal private benefits (MPB). Positive externalities are additional benefits to third parties that are not captured in the market demand curve. The social demand curve (DSocial), which includes both private and external benefits, lies above the market demand curve.Q2. If Big Drug Company faces an 8% interest rate and receives only private benefits, how much does it invest? What is the socially optimal investment?
Answer
At 8%, Big Drug invests $30 million based on private benefits alone. The socially optimal investment is $52 million (where DSocial intersects the 8% rate). The $22 million gap represents underinvestment due to positive externalities.Q3. Suppose Sony’s R&D investment in digital devices has increased profits by 20%. Is this a private or social benefit?
Answer
This is a private benefit. It represents the return that Sony itself receives from its investment. The social benefit would include any additional spillovers to other companies or society that adopt or build on Sony's innovations.Q4. The Gizmo Company has R&D investments that yield both private and social returns (social return = private return + 5%). If the interest rate is 9%, how much does Gizmo invest based on (a) private benefits only, and (b) social benefits?
Answer
(a) At 9% interest rate, Gizmo invests $102 million (the level where private rate of return is at least 9%). (b) With social benefits, a 9% social return corresponds to a 4% private return. At 4% private return, the investment level is $183 million. So the socially optimal investment is $183 million.Q5. What are the two defining characteristics of a public good? Give two examples.
Answer
A public good is (1) nonexcludable — costly or impossible to prevent someone from using it, and (2) nonrival — one person's use doesn't diminish another's. Examples: national defense (everyone is protected regardless of payment; one person's protection doesn't reduce another's) and public radio (anyone can tune in; one listener doesn't prevent another from listening).Q6. Explain the free rider problem using the prisoner’s dilemma framework.
Answer
Each person reasons: "If the other person contributes, I benefit by not contributing (free riding). If the other person doesn't contribute, I'd be foolish to contribute alone." Since both reason this way, neither contributes — the public good is never provided. This is the worst collective outcome, even though mutual contribution would make both better off. The dominant strategy for each individual is to not contribute.Q7. Which of the following are nonexcludable: (a) police protection, (b) streaming satellite music, (c) roads, (d) primary education, (e) cell phone service?
Answer
(a) Police protection — largely nonexcludable (protects a neighborhood as a whole). (b) Streaming satellite music — excludable (requires subscription). (c) Roads — mostly nonexcludable (though toll roads are excludable). (d) Primary education — excludable (private schools charge; even public schools require enrollment). (e) Cell phone service — excludable (requires paid plan).Q8. What is the “tragedy of the commons”? How does it apply to the queen conch?
Answer
The tragedy of the commons occurs when a common resource (nonexcludable but rival) is overused because no individual has an incentive to conserve it. For the queen conch: since Caribbean waters are open to all fishermen (nonexcludable) and each conch caught reduces availability for others (rival), fishermen overharvest the conch. The U.S. banned conch harvesting in 1986 after populations dropped to critically low levels.Q9. How did Elinor Ostrom challenge the traditional tragedy of the commons framework?
Answer
Ostrom (the first woman to win the Nobel Prize in Economics) argued that people can avoid depleting common resources without being forced by regulation or property rights. Through fieldwork in Indonesia, Kenya, Maine, and Nepal, she showed that communities in close proximity to shared resources can communicate and cooperate to manage them sustainably — the "non-tragedy of the commons."Q10. Why does the government subsidize vaccinations? Use the concepts of MSB and MPB.
Answer
Vaccinations have positive externalities: they protect not only the vaccinated individual but also reduce disease transmission to others. The Marginal Social Benefit (MSB) exceeds the Marginal Private Benefit (MPB). Without a subsidy, the market produces QMarket (too few). A government subsidy equal to the per-unit spillover benefit (MSB − MPB) shifts consumption to QSocial, the socially optimal quantity.Q11. HighFlyer Airlines has R&D projects with the following private returns: 12% → $100M, 10% → $200M, 8% → $300M, 6% → $400M. If the opportunity cost is 6% and the social return is an additional 2%, how much should the firm invest (a) privately and (b) socially?
Answer
(a) At 6% opportunity cost and private returns only, HighFlyer invests $400 million (all projects that return at least 6%). (b) With a 2% social premium, a 6% social return corresponds to a 4% private return. At 4%, the investment level is $500 million. The socially optimal investment is $500 million.Q12. Explain three factors behind the dramatic increase in life expectancy in the 20th century and how they relate to positive externalities.
Answer
(1) **Clean water and sanitation** — public goods (nonexcludable, nonrival) that prevented disease transmission. (2) **Changes in public behavior** — hygiene practices, reduced smoking; these behavioral changes have spillover benefits to others. (3) **Medical advances** — immunizations and antibiotics developed often through government/university-funded research (positive externalities of R&D). All three involve positive externalities where the social benefit exceeds the private benefit.8. Glossary
| Term | Definition |
|---|---|
| Common resource | A good that is nonexcludable but rival in consumption, leading to potential overuse |
| Copyright | Exclusive legal right of an author over works of literature, music, film, and pictures |
| Free rider | Person who lets others pay for a public good and then uses it without paying |
| Free rider problem | Tendency for people to avoid paying for public goods, hoping to benefit from others’ contributions |
| Intellectual property | Body of law (patents, trademarks, copyrights, trade secrets) protecting inventors’ rights |
| Marginal private benefit (MPB) | Additional benefit to the individual consumer from one more unit of consumption |
| Marginal social benefit (MSB) | MPB plus the marginal external benefit to third parties |
| Nonexcludable | When it is costly or impossible to exclude someone from using a good |
| Nonrival | When one person’s use of a good does not prevent others from using it |
| Patent | Exclusive legal right to make, use, or sell an invention for a limited time (20 years in the U.S.) |
| Positive externality | Beneficial spillover to a third party who did not purchase the good or service |
| Private benefits | Benefits received by the person or firm that consumes or produces a good |
| Private rate of return | Estimated rates of return going primarily to an individual (e.g., interest on savings) |
| Public good | Good that is both nonexcludable and nonrival; difficult for markets to supply |
| Social benefits | The sum of private benefits and external benefits |
| Social rate of return | Estimated rates of return going primarily to society (e.g., returns from public education) |
| Tragedy of the commons | Overuse/depletion of a common resource because no individual has incentive to conserve it |